Although PPP (Paycheck Protection Program) loans granted to family businesses do not require owner guaranties, it is likely that many family businesses already have debt that is guaranteed by one or more of the owners. Given the economic challenges resulting from the COVID-19 pandemic, there is a higher probability that these guaranties will come into play. Unless the guarantors have planned for that, the results may be unexpected and inequitable.
Often multiple owners of a family business execute joint and several guaranties of business debt. Most guarantors understand that “joint and several” means that the lender may obtain a judgment against any one of the guarantors for the full amount of the borrower’s obligation in the event of a default.
Many guarantors, however, also have a vague notion about a “right of contribution” under which the guarantor believes that he or she could force the other guarantors to contribute their fair share of cash to offset losses he or she might incur under any judgment on his or her guaranty. Unfortunately, rights of contribution are not that clear. In many instances, it is possible that one guarantor might bear the burden of most or all of the losses arising out of a family business loan default, without a viable claim for contribution against the co-guarantors.
Co-guarantors, however, can execute agreements among themselves and with the borrower (i.e., the family business) to better allocate the risk and to achieve a more equitable result than the law would provide in the absence of such agreements.
Joint and several personal guaranties of family business debt can create greater risk to each guarantor than he or she might realize. These risks include the following:
● A personal guaranty is usually a guaranty of “payment” not collection. This means that, in the event of a default, the lender can proceed against the guarantor without any attempt to collect from the borrower or proceed against collateral.
● Events of default include things beyond the control of the borrower or an individual guarantor. For example, the death or insolvency of a guarantor usually is an event of default. Similarly, if a guarantor attempts to revoke his or her guaranty or refuses to provide the lender with periodic updates of his or her personal financial information, the lender may deem that behavior to be an event of default. Often, the lender also will reserve the right to declare a default if there is an “adverse material change” in the borrower’s financial condition or if the lender concludes, in good faith, that the prospect of payment of the debt is impaired.
● In the event of a default, any guarantor may be held liable for all amounts owing under the loan facilities (and any other obligation that the borrower owes to the lender), including the amount of unpaid principal, interest, penalties, and the lender’s costs of collection. In addition, the guarantor will likely incur his or her own attorneys’ fees in attempting to resolve the matter.
● The lender may settle with, or entirely release, the borrower or any guarantor, without the consent of the other guarantors, and then continue to proceed against any one of the remaining guarantors for the full unpaid balance of the amounts owing to the lender.
● Sometimes the law or the loan facilities expressly foreclose a guarantor’s rights to seek reimbursement from the borrower or contribution from co-guarantors.
Perhaps the most surprising feature of the law relating to the rights or risks of a guarantor is that the common law claim of contribution can be a poor remedy for a guarantor who has paid more to the lender than the other guarantors. In particular, in some states, even if a guarantor is entitled to seek contribution, his or her right of recovery against another guarantor may be calculated in a manner that most guarantors would consider inequitable.
Under the laws of some states, the plaintiff guarantor’s right to seek contribution is limited to the amount that the plaintiff guarantor has paid in excess of his or her “percentage share” of the “total liability.” There are two principle problems with this formulation:
First, a plaintiff guarantor’s percentage share may be based simply on the number of co-guarantors, rather than on the percentage of the plaintiff guarantor’s ownership interest in the borrower. This can be especially unfair to a minority owner. For example, if the plaintiff guarantor owns 20% of the borrower, and the other guarantor owns 80% of the borrower, the plaintiff guarantor’s share of the guaranty liability may be deemed to be 50%, because the liability is split equally between two guarantors (with no reference to the amount of their respective ownership interests).
Second, the plaintiff guarantor’s share of the liability may be determined based on the amount of the total liability, even if the lender accepted less than the full amount in settlement. For example, assume that there are two guarantors and the total liability is $800,000, but the lender has accepted payment of $400,001 from one guarantor in settlement of all liability. The plaintiff guarantor’s right of contribution against the other guarantor might be limited to $1, rather than $200,000.50, because the amount that the plaintiff guarantor paid in excess of his or her share is determined based on the amount of the total liability, not on the amount that the lender accepted in settlement.
The net effect of the example in the preceding two paragraphs is that 20% owner lost $400,001 under his or her guaranty, and has a claim for contribution against the 80% owner in the amount of $1. Usually, such a result would not be consistent with the guarantors’ expectations.
One Way to Address the Risk: A Reimbursement and Contribution Agreement.
Joint and several guaranties of family business debt will always create risk for the guarantors. If the business can negotiate loans without owner guaranties or with limited guaranties, usually it should do so. Assuming, however, that joint and several personal guaranties are already in place, or are a necessary evil, the guarantors can manage the risk by executing a reimbursement and contribution agreement, including the following features:
► The borrower agrees to indemnify and reimburse each guarantor for losses arising out of the guaranty. This commitment usually will require the lender’s approval and will not be enforceable until the lender is made whole or otherwise settles its claims against the lender.
► The borrower may agree to pay an annual guaranty fee to the guarantors, to provide some compensation for the risk.
► The co-guarantors agree to a limited indemnification of one another for losses that any guarantor incurs arising out of his or her guaranty. Each indemnifying guarantor’s share of the contribution will be equal to a percentage of the amount of the indemnitee guarantor’s actual loss (rather than the amount of the total potential liability). The percentage that applies to each guarantor can be based on his or her percentage ownership interest in the borrower (at the time of the agreement or at the time of enforcement).
► Each guarantor agrees not to take any action that would constitute a default, such as attempting to revoke his or her guaranty.
► Each guarantor can agree to cooperate in obtaining life insurance whose proceeds would be available to the borrower or the surviving guarantors to manage the impact of a default caused by the insured guarantor’s death.
During these uncertain economic times, family business owners who have provided joint and several personal guaranties for family business debt, should review the loan facilities with their attorney and should consider executing a reimbursement and contribution agreement, consistent with what the lender allows.
originally written May 3, 2020